1031 Exchanges for Condominium Deconversions

Condominium deconversions have been taking place quite frequently in the greater Chicagoland area and elsewhere.  For reasons including the ones set forth below, a condominium deconversion takes place when 75% (or in some jurisdictions a higher percentage) of the owners choose to sell the building to someone interested in converting it to use as an apartment building.  A deconversion can be precipitated by one or more factors.  Rental properties may be in short supply in the area and converting the building to apartments may be far more valuable than the aggregate value of the individual condo units.  Also, as the building gets older and requires more regular fix ups, unit owners are reluctant to continuously pay for special assessments that might otherwise keep the property in proper condition.  Furthermore, the need for ongoing special assessments may make it difficult to sell the unit or at the very least have a negative impact on the price.

Requirements for a 1031 Exchange

Like any other sale of real estate, those who utilized their unit as an investment or business use property and are seeking to use a tax deferred exchange have to adhere to the specific governing regulations.  One such requirement is that the exchange company, known as a Qualified A person acting to facilitate an exchange under section 1031 and the regulations. This person may not be the taxpayer or a disqualified person. Section 1.1031(k)-1(g)(4)(iii) requires that, for an intermediary to be a qualified intermediary, the intermediary must enter into a written "exchange" agreement with the taxpayer and, as required by the exchange agreement, acquire the relinquished property from the taxpayer, transfer the relinquished property, acquire the replacement property, and transfer the replacement property to the taxpayer. Intermediary (QI), has to take tax ownership of the property from the property owner and to transfer that ownership to the buyer. Click to learn more about QI services. This can be accomplished by the taxpayer deeding the property to the QI and the QI deeding to the buyer.  Another permitted way to accomplish this is for the QI to be a party to the sale agreement, meaning that the QI has a legal obligation to cause legal title to be conveyed to the buyer.  These two options are somewhat cumbersome. In order to make that process as simple as possible, the Treasury Department provided a shortcut in the regulations to accomplish tax ownership of the relinquished property passing through the QI.

(v) Solely for purposes of paragraphs (g)(4)(iii) and (g)(4)(iv) of this section, an intermediary is treated as entering into an agreement if the rights of a party to the agreement are assigned to the intermediary and all parties to that agreement are notified in writing of the assignment on or before the date of the relevant transfer of property. For example, if a taxpayer enters into an agreement for the transfer of relinquished property and thereafter assigns its rights in that agreement to an intermediary and all parties to that  agreement are notified in writing of the assignment on or before the date of the transfer of the relinquished property, the intermediary is treated as entering into that agreement. If the relinquished property is transferred pursuant to that agreement, the intermediary is treated as having acquired and transferred the relinquished property.

In short, sellers’ “rights” in and to the sale agreement have to be assigned to the QI and all parties to the agreement have to receive written notice of this assignment. However, meeting this requirement in a sale of an individual owner’s unit presents a practical problem since typically when it comes to condominiums the sale agreement is signed only by the condominium association, and not by the actual unit owner.

Meeting 1031 Exchange Rules on a Conversion Property

In this blog writer’s shop, we attempt to bridge this gap by having slightly different language on this Assignment of Those certain items of real and/or personal property described in the relinquished property contract and qualifying as “relinquished property” within the meaning of Treasury Regulations Section 1.1031(k)-1(a); The "Old Asset”, property or properties given up or conveyed by a taxpayer as part of a 1031 exchange. Relinquished Property when it involves a sale due to conversion.  The italicized part of the assignment document appears below:

Assignment.  The undersigned (“ (“Exchangor” or “Taxpayer”) Person intending to conduct a 1031 tax deferred exchange, who transfers a relinquished property and thereafter receives a replacement property. Exchanger ”) hereby assigns to Accruit, LLC (“Accruit”) all of (“Exchangor” or “Taxpayer”) Person intending to conduct a 1031 tax deferred exchange, who transfers a relinquished property and thereafter receives a replacement property. Exchanger 's rights (but not (“Exchangor” or “Taxpayer”) Person intending to conduct a 1031 tax deferred exchange, who transfers a relinquished property and thereafter receives a replacement property. Exchanger ’s liabilities or obligations), referred to hereafter as the “Assignment”, under that certain Purchase and Sale Agreement (the “Relinquished Property Contract”) between the ____________ Condominium Association as Individual or entity that owns replacement property desired by the taxpayer. Seller , of which ___________ is a condominium unit owner as to her percentage ownership in the comment elements in the ______________ Condominium Association pursuant to 765 ILCS 605/15 of the Illinois Condominium Property Act, the unit owner being the Exchanger and Relinquished Property The purchaser of the taxpayer's relinquished property. Buyer being the buyer (identified above).  If not previously provided, simultaneously with the execution of this Assignment by the parties, (“Exchangor” or “Taxpayer”) Person intending to conduct a 1031 tax deferred exchange, who transfers a relinquished property and thereafter receives a replacement property. Exchanger shall promptly provide Accruit with a copy of the Relinquished Property Contract. 

The challenge is assigning the rights to the unit owner’s sale of the unit in a situation where the unit owner is not a direct signer nor party of the agreement.  Instead, the taxpayer is assigning the rights in his or her derivative capacity as an owner in the property being sold to the party seeking to change the property into an apartment building. Notice of the assignment is also given to the parties to the contract, usually by tendering it to their lawyers as the agent for the parties.

Sales of condominium buildings are happening regularly, and many unit owners are seeking to receive tax deferral by utilizing a 1031 exchange opportunity.  The manner in which the sale contract is signed presents a slight challenge to meet the requirements set forth in the 1031 exchange rules.  However, the spirit of those rules can be followed with an assignment of rights whereby the language in the assignment is changed slightly to account for the lack of a unit owner’s being a direct party to the sale agreement.